Fundamentals of corporate finance 5e mcgraw chapter 06

Fundamentals of Corporate Finance Chapter Valuing Stocks Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Topics Covered Stocks and the Stock Market Book Values, Liquidation Values and Market Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks There are no free lunches on Wall Street Market Anomilies and Behavioral Finance McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Stocks & Stock Market Primary Market - Place where the sale of new stock first occurs Initial Public Offering (IPO) - First offering of stock to the general public Seasoned Issue - Sale of new shares by a firm that has already been through an IPO McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Stocks & Stock Market Common Stock - Ownership shares in a publicly held corporation Secondary Market - market in which already issued securities are traded by investors Dividend - Periodic cash distribution from the firm to the shareholders P/E Ratio - Price per share divided by earnings per share McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Stocks & Stock Market Book Value - Net worth of the firm according to the balance sheet Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time Sometimes called the holding period return (HPR) Div1 + P1 − P0 Expected Return = r = P0 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks The formula can be broken into two parts Dividend Yield + Capital Appreciation Div1 P1 − P0 Expected Return = r = + P0 P0 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends Div1 Div2 Div H + PH P0 = + + + H (1 + r ) (1 + r ) (1 + r ) H - Time horizon for your investment McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively At the end of three years you anticipate selling your stock at a market price of $94.48 What is the price of the stock given a 12% expected return? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 10 Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively At the end of three years you anticipate selling your stock at a market price of $94.48 What is the price of the stock given a 12% expected return? 3.00 3.24 350 + 94.48 PV = + + (1+.12) (1+.12) (1+.12) PV = $75.00 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 18 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 20% What is the value of the stock before and after the plowback decision? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 19 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to blow back 40% of the earnings at the firm’s current return on equity of 20% What is the value of the stock before and after the plowback decision? No Growth P0 = = $41.67 12 McGraw-Hill/Irwin With Growth g =.20×.40 =.08 P0 = = $75.00 12 −.08 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 20 Valuing Common Stocks Example - continued If the company did not plowback some earnings, the stock price would remain at $41.67 With the plowback, the price rose to $75.00 The difference between these two numbers (75.0041.67=33.33) is called the Present Value of Growth Opportunities (PVGO) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 21 Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 22 No Free Lunches Technical Analysts Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”) watchers McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 23 No Free Lunches Scatter Plot of NYSE Composite Index over two successive weeks Where’s the pattern? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 24 Random Walk Theory The movement of stock prices from day to day DO NOT reflect any pattern Statistically speaking, the movement of stock prices is random (skewed positive over the long term) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 25 Random Walk Theory Coin Toss Game Heads Heads $106.09 $103.00 Tails $100.43 $100.00 Heads Tails $97.50 Tails McGraw-Hill/Irwin $100.43 $95.06 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 26 Random Walk Theory McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 27 Random Walk Theory McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 28 Random Walk Theory Market Index 1,300 1,200 1,100 Cycles disappear once identified McGraw-Hill/Irwin Last Month This Month Next Month Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 29 Another Tool Fundamental Analysts Research the value of stocks using NPV and other measurements of cash flow McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 30 Efficient Market Theory Weak Form Efficiency Market prices reflect all historical information Semi-Strong Form Efficiency Market prices reflect all publicly available information Strong Form Efficiency Market prices reflect all information, both public and private McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 31 Efficient Market Theory Announcement Date McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 32 Behavioral Finance Attitudes towards risk Beliefs about probabilities McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved [...]... movement of stock prices is random (skewed positive over the long term) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 25 Random Walk Theory Coin Toss Game Heads Heads $ 106. 09 $103.00 Tails $100.43 $100.00 Heads Tails $97.50 Tails McGraw- Hill/Irwin $100.43 $95 .06 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 26 Random Walk Theory McGraw- Hill/Irwin... Present Value of Growth Opportunities (PVGO) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 21 Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill... information, both public and private McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 31 Efficient Market Theory Announcement Date McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 32 Behavioral Finance Attitudes towards risk Beliefs about probabilities McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All... equity of 20% What is the value of the stock before and after the plowback decision? McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 19 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to blow back 40% of the... prices (thus “wiggle watchers”) watchers McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 23 No Free Lunches Scatter Plot of NYSE Composite Index over two successive weeks Where’s the pattern? McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 24 Random Walk Theory The movement of stock prices from day to day DO NOT... percentage of earnings plowed back into operations g = return on equity X plowback ratio McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 18 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to plow back 40% of the... Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model) Div1 P0 = r−g Given any combination of variables in the equation, you can solve for the unknown variable McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 14 Valuing Common Stocks Example What is the value of a stock that expects to pay... McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 27 Random Walk Theory McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 28 Random Walk Theory Market Index 1,300 1,200 1,100 Cycles disappear once identified McGraw- Hill/Irwin Last Month This Month Next Month Copyright © 2007 by The McGraw- Hill Companies, Inc All rights... Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 16 Valuing Common Stocks  If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher Payout Ratio - Fraction of earnings paid out as dividends Plowback Ratio - Fraction of earnings retained by the firm McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies,... expected return Instead, we decide to blow back 40% of the earnings at the firm’s current return on equity of 20% What is the value of the stock before and after the plowback decision? No Growth 5 P0 = = $41.67 12 McGraw- Hill/Irwin With Growth g =.20×.40 =.08 3 P0 = = $75.00 12 −.08 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 20 Valuing Common Stocks Example - continued If the